Assume that today is January 1,2017. The rate of inflation is expected to be 4% throughout 2013. However, increased government deficits and renewed vigor in the economy are then expected to push inflation rates higher. Investors expect the inflation rate to be 5% in 2018, 6% in 2019, and 7% in 2020. The real risk-free rate, k* is expected to remain at 2% over the next 5 years. Assume that no maturity risk premiums are required on bonds with 5 years or less to maturity.

2. What is the average expected inflation rate at the end of 4 years?
4. What is the quoted interest rate on 4-year T-bonds?

The real risk-free rate of interest is 3%. Inflation is expected to be 2% this year and 4% during the next 2 years. Assume that the maturity risk premium is zero.

2. What is the nominal interest rate on 2-year treasury securities?
4. What is the nominal interest rate on 3-year treasury securities?

Suppose that the annual expected rates of inflation over each of the next five years are 5%,7%,9%,13% and 12%, respectively. What is the average expected rate of inflation over the 5-year period?

Suppose you and most other investors expect the inflation rate to be 7% next year, to fall to 5% during the following year and then to remain at a rate of 3% thereafter. Assume that the real risk-free rate, k*, will remain at 2% and that maturity risk premiums on treasury securities rise from zero on very short-term bonds (those that mature in a few days) to a level of 0.2% point for 1-year securities. Furthermore, maturity risk premiums increase 0.2% point for each year to maturity, up to a limit of 1.0% point of 5-year or longer-term T-bonds.

2. Calculate the interest rate on 1-, 2-, 3-, 4-, 5-, 10- and 20-year treasury securities, and plot the yield curve.
4. What the yield curve have looked like?
6. Describe the general economic conditions that could be expected to produce the yield curve at (b).

Let assume that today is January 1,2017. The rate of inflation is expected to be 4% throughout 2017. However, increased government deficits and renewed vigor in the economy are then expected to push inflation rates higher. Investors expect the inflation rate to be 5% in 2018, 6% in 2019, and 7% in 2020. The real risk-free rate, k* is expected to remain at 2% all over the years. Investors also demand a 1% premium for each year until maturity for any debt, with a maximum value of 10%.

From the above information you are required to:

1. Compute the interest ratefor a one-, two-, three-, four-, and five-year bond.

(5 marks)

1. If inflation is expected to equal 8% every year after 2020, what should be the interest rate for a 10- and 20-year bond?

(2 marks)